Living with the Bear

By KEVIN ARMSTRONG

Even after the past few months of rising sharemarkets, investors the world over are severely chastened after the deepest, and longest, bear market of the past 70 years.

Many are still questioning whether there really should be a place for shares in their investment portfolios and, in particular, in their pension funds.

The once-popular - but always over-simplistic - observations that it is, "time in, not timing" that matters and that "equities always outperform all other assets over the long-term" are now wearing thin.

Academic studies now emerging demonstrate that bonds yielded the same returns as shares since the early 1980s and that perhaps it is imprudent for pension funds to own any shares at all. Attitudes towards investment have certainly changed over the past three years.

Investors who are still prepared to look at shares may be slightly encouraged by the rallies of the past few months. However, uncertainties over the world's economic future still abound as no clear evidence of a "normal" and enduring recovery has been seen.

Investors want a clear signal that it is fine to get back into the market and that all the troubles of the past few years are behind us. Unfortunately, just as no one rang a bell three years ago at the peak to indicate trouble ahead, no one is going to sound the all-clear.

In fact, waiting for the all-clear will probably prove no more rewarding than waiting for confirmation of trouble gave protection; it was generally heard only after much of the fall had already occurred.

But many still look to (Sir) Alan Greenspan, head of the US central bank, the Federal Reserve, to mastermind the US economy in such a way that a definitive all-clear will be given.

From the time Greenspan came to office, just before the crash in 1987, his reputation grew and grew. It appeared that his stewardship of monetary policy could ensure that the business cycle was dead and that recessions were a thing of the past. He was frequently described as the greatest central banker in history and even received an honorary knighthood from the Queen as the US enjoyed its longest economic expansion ever.

On Wall St there is an old adage, "Don't confuse genius with a bull market". Is it possible that Greenspan merely got in the way of the expansion of the 1990s rather than created it? This observation would have been tantamount to heresy three years ago, but now, after the suffering of so many over the past three years, it is a question that should at least be examined given that so many still look to Greenspan for clear guidance.

Perhaps his most famous quote came in December 1996 when he used the term "irrational exuberance" to describe the behaviour of equity investors. The words were immediately seized on throughout the investing world as the bell investors had been waiting for to signal the end of what, until then, had been a very healthy and enduring bull market. Markets initially plunged several per cent only to recover shortly after.

Then the great bull market really got going, fuelled by Greenspan's easy money following the Asian crisis and most notably in the bailout after the collapse of Long Term Capital Management.

Low interest rates and the belief that the Fed would do whatever was necessary to support the market prompted speculation in shares, and technology shares in particular, the like and scale of which has rarely been seen before, as perhaps the largest speculative bubble in history inflated.

Through this period of speculation everyone's confidence grew, from individual investors through to economists and even central bankers. Rather than continue with his concern over irrational exuberance, the more the markets rose and the economy continued to expand, the more Greenspan became an outspoken supporter of the "new economy" and its associated "productivity revolution".

Some of his comments at the time echoed those made 70 years earlier, just before the Great Crash and the Depression, by economist Irving Fisher, who believed that, "Stock prices have reached what looks like a permanently high plateau".

Through the early stages of this latest bear market and recession Greenspan, with most forecasters, remained optimistic even as the world's sharemarkets continued to decline.

Most economists denied the possibility of a US, let alone a global, recession until long after it had in fact started in March 2001.

So now it is clear that a bear market of historic proportions has already occurred, who should we look to, to sound the all- clear? Unfortunately, it is unlikely to be found in the comments of a central banker, or even of most economists, whose forecasts have tended to follow rather than lead the Fed, the economy and the share market.

Back in 1999 and into 2000 there was widespread belief in and acceptance of the "new paradigm" and very few economic forecasters had the next recession anywhere in the near future, even though it was only a year away.

Since then, growth forecasts for both the US and the world have been ratcheted down as actual economic growth has continued to disappoint and surprise on the negative side.

Now, after the worst bear market in shares for the past 70 years, forecasts for a recovery are continually being pushed further out into the future. Even the previously overly optimistic Greenspan was sounding more cautious at the recent sharemarket lows and concerned about the prospect for any sort of recovery in the US. The tone of the Fed chairman understandably filtered down to most economic forecasters, in spite of his now-deteriorating track record.

Ironically, in his most recent testimony, Greenspan was sounding a little more upbeat, while still warning of the dangers of deflation. Of course, this was after world share markets have rallied between 20 and 50 per cent!

If the 75-year-old Fed chairman does indeed take on a record fifth term in office, it is highly questionable whether history will be as kind to him as it would have been three years ago.

There is now a great uncertainty as to the world's economic outlook and also the durability of this recent bull market in shares. There is still an awful lot to worry about in the world, both geopolitically and economically, but history has repeatedly shown that in investing, the absolute best buys do not come when everyone is highlighting them and the future seems rosy and assured.

Is it possible that the bottom in sharemarkets has already been seen? If it has, then most markets bottomed between October last year and May, just when the mood of most investors (and central bankers) was at its gloomiest; it does not appear that anyone did ring a bell at the time.

It is unlikely that these moves, impressive though they have been, will prove to be the start of a bull market like that seen in the 1990s. There could certainly be more to come, particularly given the vast sums now earning virtually zero in cash and money market accounts that could be moved into shares at some time.

Adopting an extremely cautious stance now, because things have been bad, is likely to be as useful as being optimistic was in 2000 just because things had until then been as good as they had ever been.

No one person or tool is going to give investors an all-clear at the bottom of any bear market. Not even a great central banker.

Successful sharemarket investing is not solely down to having a perfect view of the economic future; it depends a lot on what all other investors are expecting too.

Economist John Maynard Keynes summed up this aspect of investing as follows: "Successful investing involves the anticipation of others' anticipations".

If the economic future is only slightly less bad than many currently expect, the surprise from here may be just how high markets are when an actual recovery has been seen, and, unfortunately, just how many investors waited too long before finally feeling comfortable and confident enough to invest.

* Kevin Armstrong is chief investment officer, private banking division, at the National Bank of New Zealand. The views expressed in this article do not necessarily reflect the views of the bank.